08 July 2013

A tail's tale

The maximum rate of Newstart allowance (NSA) has been the subject of much debate recently, but it’s not the only contentious aspect of that payment.  Another commonly raised issue is the effective marginal tax rates (EMTR) faced by NSA recipients (and those on payments with related income tests, such as partnered parenting payment) who have some private income, particularly earnings.  In truth, in most cases the EMTRs are actually quite a bit lower than they used to be – NSA once had an income test with a 100% withdrawal rate, whereas the highest taper these days is 60%.   There are, however, some persistent problem areas and one of these lies at the tail end of the income test for couples.  There, EMTRs remain stubbornly high and the reasons underlying this raise interesting issues involving differences in the fundamental basis of assessment between the tax system and the transfer system, and also the flow on effects of tinkering in different parts of the system.

In fact, there are so many issues involved in just this one case that I’ve found it difficult to know how to tackle them all in a coherent way.  In the end I’ve decided to take a broadly chronological approach, starting with an EMTR(ish) chart for a single income couple with a couple of young children, as at 20 September 2001.  This reflects the position left by Parliament 39 and inherited by Parliament 40.

Chart 1: EMTR 20 September 2001 (in 2013 dollars)

 (The following paragraph gives some explanation for the “jaggies” in the chart.  You can safely skip it if they don’t bother you)
First up I should deal with an issue that will otherwise distract those readers familiar with EMTR charts.   I confess that this isn’t really a “proper” one at all.  The chart is actually showing what the effective average tax rate is over successive increments of $250 a year (in 2013 dollars).  Traditionally, EMTRs are measured on the next $1, whereas mine uses roughly the next $5 a week.  That, and the method I’ve used to convert 2001 results into 2013 dollar values makes for some jagged edges in my pictures that in classic depictions would be smooth vertical lines.  But for the purposes of this post, the odd jagged edge is neither here nor there, so just accept my apologies and we’ll move on.

In this chart the EMTR is represented by the black line (Total), with the coloured areas distinguishing the various tax-transfer components that underlie the result.  For example, at $10,000 of private income the Total line (ie, the EMTR) is 75.1%.  It’s made up of the NSA income test withdrawal rate of 70% (the orange area) and a tax impost of 5.1% (the red area).

We can also see that at the end of the withdrawal of partner 2’s parenting payment (starting at roughly $33,000) the EMTR has reached 100%, and continues at that rate until the end of the partner 2 payment range at roughly $36,000.
The high EMTR at the tail end of the income test is the focus of this post, but explaining it brings into play two concepts that require a look at the results at lower incomes.  These are highlighted at a private income of around $20,000 when the tax rate jumps up, but the EMTR nonetheless falls.  That’s the point at which the income of Partner 1 (P1) has reduced the NSA payment to nil and has begun to affect the entitlement of Partner 2 (P2).

The fact that the tax rate rises at the point where P1’s NSA has run out is important.  Back in 2001 the first tax rate in the income tax system was 17%, but as alluded to above, it’s not 17% that’s being applied to P1 during withdrawals of NSA at incomes above approximately $8,000.  (Note that the higher rate applied at incomes up to around $8,000 is actually a combination of income tax and tax-rebate withdrawal – it’s not solely income tax).  Why isn’t it 17%?  It’s because each dollar increase in private income is reducing NSA – which is taxable for income tax purposes - by 70 cents in the dollar.  The result is that a dollar increase in private income gives an overall boost to taxable income of only 30 cents.  From the perspective of the income tax system it’s the 30 cent increase that’s important, and tax is ultimately levied on it, not the original one dollar.  17% of 30 cents is 5.1% and it’s this rate that applies during the latter part of P1’s NSA withdrawal.  Taking into account the reduction in NSA and the applicable income tax, the EMTR is 70% + 5.1%, for a total of 75.1%, as shown on the chart.
Once P1’s NSA has run out (at around the $20,000 mark) this interaction between NSA reduction and income tax stops happening and the (then) standard 17% tax rate kicks in.  At this point I’m kind of hoping that you might wonder why the interaction stops – after all, it’s clear from the chart that while NSA might have been exhausted, P1’s rising income is still reducing the income support payments to P2 at 70 cents in the dollar.   Therein lies a crucial difference between the tax system and the transfer system – the unit of assessment in the former is (largely) the individual, whereas it’s family based for the latter.

That difference means the fact that P1’s income is being used by the transfer system to reduce P2’s payments is effectively invisible to the income tax side.  P1 is being taxed as if that isn’t happening.  This leads to our first major point – if a person’s income reduces their own taxable income support payment, then their tax liability will effectively take this reduction into account; if it reduces someone else’s income support, tax is not adjusted.
You’ll notice however that although the reductions in P2’s payment are being ignored for tax purposes, resulting in P1’s tax rate increasing from 5% to 17%, the EMTR has actually fallen.  That’s due to Family Tax Benefit Part B, which shows up with a negative value on the chart.  But before I get into what’s going on there it’s probably time to move forward to the next date of interest – 20 September 2004 – and its chart..

Chart 2: EMTR 20 September 2004 (in 2013 dollars)


This chart reflects the system bequeathed to Parliament 41 by Parliament 40.  Here we can see that the tail end of the income support withdrawal now has a significant range where the EMTR is 104%!  EMTRs over 100% are dreadful, no two ways about it, with the word “theft” coming to mind.  (Where I worked there was a little joke going round at the time – not only was the Government taking every last cent of any increase in income in that range, it also charged a 4% handling fee for doing so.)
While it’s obviously the case that EMTRs of this magnitude mean that more work results in less money, there’s another problem, particularly for those keen on promoting workforce participation.  It’s the perverse outcome that working less will give a financial gain.  In the case shown in the chart, a worst-case example would see someone earning $34,500 getting an increase in disposable income of around $200 a year by reducing their working hours to earn $29,500 instead.  Clearly, this is not consistent with any of the “messaging” governments like to send about incentives in the system.

Pleasingly, the 104% problem disappeared as a result of changes made during the course of Parliament 41, but before turning to that it’s time to deal with the blue blob of FTB B.
If you look back at Chart 1 you’ll see that potential for a 104% problem existed even then (see the approximate income range from $28,000 to $33,000).  It’s just that the negative, or offsetting, effect of FTB B operated to pull down the overall EMTR.  In Chart 2 we can see that the FTB B offset no longer extends into the income range where 104% can occur.  There’s also another change – the reduction in EMTR that FTB B is providing is not as great in Chart 2.  Indeed, in Chart 1 the impact of FTB B is so substantial that the EMTR actually falls at the point where P1 NSA is exhausted and P2 parenting payment starts reducing.

But how does FTB B offset EMTRs at all, and what happened during Parliament 40 to change the FTB B interaction, leading to a 104% EMTR?
Some background is useful here. For couples, FTB B was originally targeted at households where one partner had all or most of the income – single income couples, more or less.  To make that targeting work, FTB B has to have an income test on the “second earner” (the one with the lowest income) so that FTB B can be (gradually) withdrawn as second earner income increases and the couple moves away from being “single income”.  As the name suggests, the second earner test only counts the income of the second earner but, importantly, this includes any income support they may receive.  In the examples used in the charts P2 is the second earner, so P1’s income is not taken into account in the second earner test, but P2’s parenting payment is.

On the face of it, if P1’s income is not taken into account for FTB B then the fact that P1’s income increases as we go along the income axis of the chart shouldn’t affect the FTB B rate.  That’s true enough – it doesn’t directly affect FTB B, but it does have an indirect impact via the parenting payment.  As P1’s income rises it eventually – at about $20,000 - starts to reduce P2’s parenting payment at the rate of 70 cents in the dollar (remember we are talking about 2004 here).   This means that P2’s income, in the form of parenting payment, is falling and it’s this reduction in P2 income that leads to an increase in FTB B.
The increase in FTB B partially offsets the decrease in parenting payment, which is why it shows up on the charts as a negative component of the EMTR.  There’s a limit to this process though.  Once FTB B reaches its maximum rate it obviously cannot increase further and so the offset process stops. 

After that lengthy explanation it’s now possible to explain what happened during Parliament 40 that led to the unleashing of a 104% EMTR rate.  Then, as now, the incentives for second earners to take up or increase work were a matter of some concern.  To improve these incentives the FTB B income test was relaxed in two ways: the withdrawal rate was reduced from 30 cents in the dollar to 20, and the amount of income that could be had by the second earner before FTB B began to reduce at all (the income test free area or amount) was increased.

These measures were designed to lower the EMTR faced by second earners but they also had the effect of worsening them for first earners.  In the charted example, the increase in the FTB B income test free area meant P2’s parenting payment did not have to be reduced as much by P1 income before FTB B reached its maximum rate.  Via the indirect mechanism of parenting payment reduction, the FTB B offset effect that pulled down P1’s EMTR now stopped happening at a lower level of P1 income.  This meant that more of the tail end of the NSA-PP income test was subject to high EMTRs.  Welcome to the 104 nightmare.
Incidentally, the lowered withdrawal rate for FTB B, meant to reduce EMTRs for second earners, also made them worse for second earners in low income households.  Put simply, the withdrawal of FTB B under the second earner test now operated in tandem with the parenting payment income test over a longer range of income than before.   That is perhaps a little off topic, but it does go to the main point of this FTB B discussion – apparently well-intentioned adjustments to one payment (in this case FTB B) can have regrettable effects elsewhere in the system.  In the FTB B case, the decision to improve work incentives via a relaxation of the income test actually worsened them for income support households trying to improve their financial position through extra work, for first and (often) second earners alike.
So, having inherited the 104% monster, what success, if any, did Parliament 41 have in slaying it?  Here’s how things looked by the time it had done its work.

Chart 3: EMTR September 2007 (in 2013 dollars)


Now this is looking conspicuously like a success story, at least in terms of getting the EMTR back under 100%.  The reason it fell is simply a consequence of the decision to reduce the NSA (and similar payment) top income test taper rate from 70 cents in the dollar to 60.  There is still a substantial jump in the EMTR when P1 income reaches roughly $35,000 (again, this is expressed in 2013 dollar values) where the tax rate (including the withdrawal of the low income tax offset) becomes 34%.  But 34 + 60 is still better than the previous 34 + 70 regime.
Unfortunately, relaxing the NSA, etc, income test also had a bit of an unpleasant flow-on.  If you look back at charts 1 and 2 you’ll notice that the medicare levy only appears on the scene after the two income support payments, NSA and PP, have been withdrawn.  However, in Chart 3 we are beginning to see medicare withdrawals sitting on top of the income support and tax stack, taking the EMTR up to a rather bracing 99%.  This happens because reducing the NSA taper rate to 60% extends the income range over which NSA and PP are paid.  This in turn means that the household’s taxable income (earnings plus taxable income support) is higher in these ranges than before the income test relaxation.  This then makes the household liable for the medicare levy at a lower level of private income than before.

Nonetheless, progress has been made.  So how did things develop over the next Parliament?  Here’s how it looked after Parliament 42 was through.

Chart 4: EMTR July 2010 (in 2013 dollars)


Note that this Parliament (42) finished up a little earlier than those in the previous charts.  As a result it was the tax-transfer system at July 2010, rather than September, that was in place at the election date.
Here we can see that quite substantial progress has been made in reducing the tail end EMTR, mainly due to the increase in the income level at which the second tax rate (34%) commenced.  While a stack of PP withdrawal + tax + medicare is still evident, it’s now quite confined, limiting the 99% EMTR to a little over a $1,000 a year income range.

At this point things are/were looking good, at least compared to the 104% horror period.  There had been two Parliaments in a row where the EMTR fell – can Parliament 43 continue this improving trend?  At the time of writing Parliament 43 is still a going concern, albeit almost at the end of its allotted time.  However, there are no scheduled changes to the tax transfer system that are relevant to this discussion between now and the latest possible election dates in November, except for a CPI adjustment to income support rates on 20 September 2013.  That means the system now in place is pretty much the same as it will be at the election.  So what does it look like?

 Chart 5: EMTR July 2013


Alas!  Things have worsened!  There’s been an obvious increase in the income range over which the 99% parenting payment + income tax + medicare EMTR stack is present, which is entirely due to the lack of change in the 34% income tax threshold (ie, it’s a kind of bracket creep).  Barely visible at this scale is an increase in the EMTR to almost 104% (again with that number!) at the end of the tail, caused by the inclusion of a non-taxable clean energy supplement into the rate structure for parenting payment (and NSA).   Also apparent are two spikes, at the end of the withdrawal range for NSA and PP respectively.  These come from the design of the income support bonus (see here for details) and the flawed integration of the clean energy supplement into the sequential income test used for these payments (see here for details).
But wait – there’s more!

While the above picture represents the situation at the coming handover between Parliaments 43 and 44, there are two decisions that have been passed by Parliament 43 which, unless Parliament 44 decides otherwise, will come into effect during its term.  Both are intended to assist people in one way or another, but like the earlier well-intentioned changes, come at the cost of making things worse somewhere else in the system.
These decisions are:
  • increasing the medicare levy to 2% as part of the funding arrangements for the NDIS; and
  • increasing the income test free area for Newstart allowance (and related payments) from $62 a fortnight to $100 a fortnight.
If we apply these two decisions to the current tax-transfer system we get the following result:

Chart 6: EMTR - projected (2013 dollar values)

Here we can see that the 99% range has grown further.  In fact it will have grown so much that all the gains made by Parliaments 41 and 42 on the income test tail EMTR reduction front will be wiped out.  We are also going to get a stack occurring with FTB Part A, income tax and medicare, taking the EMTR in the approximately $49,000 area to over 60%.

So there you have it.  An EMTR dragon at the tail of the NSA couples’ income test that was almost slain, but has now bounced back dangerously close to its former infamy.  Can something be done to fix this recurring issue (assuming of course it’s something we should fix)?
You can be forgiven for thinking that the interactions between these various entitlements and imposts is so complicated that it’s just not possible to factor every piece of interplay into decision making.  Or instead, you might think that attempting to do so would just result in a kind of policy paralysis where nothing is done for fear of unintentionally disturbing some imagined fine balance.

I’d prefer to think that it’s possible to make changes in a more considered way than we have managed so far, even if perfection in design is unattainable.  To that end I’m encouraged by the establishment of the Tax and Transfer Policy Institute at the ANU Crawford School of Public Policy.  One of its objectives is better designed tax and transfer systems in Australia.
Still, I’m not putting too much faith in it.  It seems to me that past reviews that combine tax and transfer issues end up focussing on tax, with transfers as an annoying afterthought.  The Henry Review, for example, seemed to do not much more than recommend the status quo on the transfer side.  It notably squibbed on an issue that is central to a number of the EMTR problems – the different unit of assessment (individual versus family) across taxes and transfers - basically putting it in the too hard basket.  Unfortunately for families, that’s not an approach which helps much.

The Tax and Transfer Policy Institute is, however, not just another review so perhaps it’s reasonable to hope, even if only a little, for fresh perspectives.  I guess we’ll have to wait and see.

1 comment:

  1. Colin Hargreaves7 October 2014 at 13:55

    It would be good to show how low are the EMTRs for those earning up to $200,000, especilly given voluntary super deductions.